National Institute of Economic and Social Research

Thursday, 24 May 2012

Chris Giles: evidence based analysis, but not so the conclusions

Chris Giles' FT piece here argues essentially that the political debate focuses too much on fiscal policy; and that given the uncertainty about the impacts past and future, of fiscal policy, economists should refrain from taking sides in this debate. I think that while there is much in Chris' piece that I agree with, ultimately his conclusions are confused at best, and damaging at worst. I shall make extensive reference to his points below, but I don't want to misrepresent him, so please do read his piece first!

Chris begins by attacking politicians (Messrs. Cameron and Balls) for talking nonsense about the impact of the deficit. Well, hold the front page. I suspect that everyone who reads both his columns and this blog (yes, that's you at the back in the Treasury, don't you have work to do? Didn't the DPM tell you to think up a way of taking the A14 bypass off balance sheet?) knows that they are straw men.

But, in this preamble, Chris also endorses, directly or implicitly, several very important arguments:

that the main macroeconomic problem facing the UK at present is the lack of demand (he emphasises his basic agreement with the IMF, who put this point front and center earlier this week);

that this problem is caused, at least to some extent, by rapid fiscal consolidation. "Deficit reduction plans might be hitting the economy harder than I and the UK authorities imagined."

that low interest rates are fundamentally the result of economic weakness, rather than somehow a sign of "confidence" in government economic policies; "by far the most important reason for low interest rates is the belief that weak growth will foster easy monetary policy for the foreseeable future";

that the prospect of a bond market panic in the event of a slowing of the fiscal consolidation is small to zero (he certainly doesn't mention this is as being a significant argument against such a policy, and nor do the Fund).

The first point is a welcome - and to give Chris due credit, commendably honest and upfront - confession of error. Just a year ago he was arguing that the UK's weak (now non-existent) recovery was nothing at all to do with a lack of demand, and that therefore there was nothing that either monetary or fiscal policy could do about it. Later he argued that it was the result of unexpected inflation. Unlike many other economists, he is prepared to be Keynesian on this point ("When the facts change, I change my mind; what do you do?"). Good for him.

So he has essentially accepted the basic analysis that Martin Wolf and I have been making for some time. It is where this comes to policy implications that he, like the IMF, decides to hedge his bets. That is all very well, but it is also here that he rather gives up on basing his argument on analysis. The IMF has the excuse - as he rightly pointed out in his article, and as Stephanie Flanders pointed out much more directly here - that they are politically constrained in following their arguments to their logical conclusion. But Chris doesn't have this excuse. Essentially he makes two points:

first, that slowing the pace of fiscal consolidation should be the last resort, because "monetary policy should be the first port of call for demand management".

second, that fiscal consolidation should only be slowed when "evidence that the beneficial effect of a fiscal stimulus now was much greater than the inevitable consolidation later."

There is at least some economic theory behind the first prescription; indeed, I used to believe it myself, as I set out here. But this is a purist approach, which simply hasn't survived contact with reality, as Chris' own articles show. If monetary policy alone was indeed enough in practice, we wouldn't be where we are now, with unemployment in the UK a million higher than the official estimate of the natural rate, and no prospect of it coming down in the immediate future. Any demand management policy that delivers that outcome is not one that policymakers should regard as remotely adequate.

Why have things turned out this way? Well, economists will be arguing about this for some time. As Milton Friedman famously said, monetary policy has long and variable lags; and he was talking about conventional monetary policy operated through interest rates, not the present extraordinary measures. It is clear the Monetary Policy Committee, let alone the rest of us, has no idea of the impact, of any, of their monetary policy actions; in these circumstances, it is absurd to argue that all the weight of demand management should axiomatically fall on those actions. We may (as Chris fairly points out) not know the exact impact of a large infrastructure programme on output and employment; but almost all economists think it would be positive and significant. And if he thinks the money would be better spent on programmes directly addressing youth unemployment: well, there is an extremely strong case for doing just that.

But I disagree even more fundamentally with the second argument. Chris is arguing that we should accept substantial economic damage, both now and in the future - as he rightly says "economic stagnation is creating permanent scars, particularly through high levels of youth unemployment" - in order to avoid the unknown, but almost certainly smaller, costs of future fiscal consolidation.

Since we don't disagree that the costs of the current trajectory are likely to be large and permanent,, and that the potential benefits (at least) of changing course are similarly important, it's worth setting out why the likely costs of future consolidation are, contrary to Chris' (unevidenced) assumption, likely to be very small:

first, and most importantly, current borrowing costs. It is entirely true that a large £30 billion infrastructure programme, financed by government borrowing, increases the cost of the necessary future fiscal consolidation - as Chris rightly says, that's "inevitable". By how much? Perhaps £150 million a year at current real interest rates, as I set out here - the revenues raised by the pasty tax or its future equivalent. Is this a price worth paying? Of course it is. It cannot be repeated too often:

"with long-term government borrowing as cheap as in living memory, with unemployed workers and plenty of spare capacity and with the UK suffering from both creaking infrastructure and a chronic lack of housing supply, now is the time for government to borrow and invest. This is not just basic macroeconomics, it is common sense."

slightly more technically, asymmetric multipliers. Since all borrowing has to be paid back in the end, running a larger deficit now doesn't reduce the tax burden (or increase the amount you can spend) over time. But the impact of deficits does vary; a deficit now, when there is lots of spare capacity, is likely to have a significant positive impact on output (a large fiscal multiplier). By contrast, if we pay it back in the future when the economy is at or near capacity, the negative impact is likely to be small or zero (the multiplier will be small or zero), a point forcefully made in the influential paper by DeLong and Summers here:

iii) reversibility. As Simon Wren-Lewis argues here, the risk calculation goes precisely the opposite way to Chris' assertion. However, unlike Chris, he bases his argument on some proper economic reasoning. When monetary policy is at, as is now, at the zero lower bound, then "with a one way insurance policy, its best to go for an overshooting policy to some degree." While Simon's article is quite techy, the basic insight is that if fiscal policy is too loose, you can always correct through monetary policy, by reversing QE or raising interest rates. But if it's too tight, you're stuffed, as we are now. So we should be aggressive on fiscal policy - if we overdo it, we can correct. By contrast, if we err on the other side, the permanent damage is, as Chris admits, permanent.

What's Chris' counterargument to these points? Merely a vague assertion that if we change course now we'd jeopardise credibility, in some unspecified way and with unspecified consequences. But the temporary fiscal loosening of the sort Martin and I propose is entirely consistent with the government's own fiscal framework, which relates only to the future structural deficit. And as Martin says, "willingness to inflict economic pain is rarely a route to credibility."

So while Chris' article is a good read, and it appeals to those who are inherently uncomfortable with taking sides in a complex economic debate, it is ultimately disappointing. Much of the analysis is evidenced-based; the policy conclusions, or lack of them, are not.